Refinancing for home improvement: How it works

Strategic home improvements can substantially increase your home’s value (read: price tag at selling time), but they come at a cost. Often, a well-into-the-five-figures cost. If you don’t have the savings to cover the project — or don’t want to deplete them to do so — it’s worth exploring how refinancing your mortgage can help pay for it.

Refinancing for home improvement involves a specific type of transaction, a cash-out refinance. A cash-out refi can help you get on the pathway to turning your current home into your dream home. But refinancing for home improvement has its downsides, too. Let’s dig into how it works, and the pros and cons.

How to refinance for home improvements

In a cash-out refinancing (cash-out refi for short), you replace your existing mortgage with a larger home loan, taking the difference out in ready money. The amount you can get is based on the worth of your home, and how much of it you actually own (as opposed to still owing on your mortgage). It leverages your home equity, in other words.

Your new mortgage will have different terms, possibly higher monthly payments and a different interest rate — sometimes higher than what you had originally. On closing day, when the new loan is finalized, the lender would give you a check in the amount of your cash-out funds. You’d start repaying the money — both the mortgage and the cash-out funds —  in monthly installments, just as you did your old mortgage.

Let’s say you still owe $70,000 on your home, which has an appraised value of $250,000, and you decide you want to add an in-law apartment (a little home-within-the-home) to your residence. With a cash-out refinance, you can get a new mortgage up to $200,000, which would pay off the $70,000 debt and leave you with $130,000 (a bit less than that after closing costs) to use for the renovation.

Why $200,000? Because most lenders require that the size of your new loan equal no more than 80 percent of the value of the home, a figure known as the loan-to-value (LTV) ratio. In this case, with your home worth $250,000, $200,000 keeps you within an 80-percent LTV.

Qualifying for a cash-out refinance

A cash-out refinance is a new mortgage, so you will have to qualify, meeting the lender’s criteria — even if you’re using the lender of your original loan. Among the requirements:

• Good or excellent credit: A good or excellent credit score is typically 670 or higher.
• Low debt-to-income (DTI) ratio: Your DTI is your total monthly income relative to your total monthly debts. Ideally, lenders will want this number to be around 36 percent, though some will accept DTIs of 43 percent.
• Loan-to-value ratio: Most lenders require that you have an LTV ratio below 80 percent. To determine your LTV, divide your outstanding mortgage balance by the market value of your home, then convert that number to a percentage.
• Decent income: In addition to adequate home equity, you’ll also need consistent income to qualify for a cash-out refinance. Income requirements vary by lender.  In today’s high-rate environment, you’re going to need to demonstrate that you’re earning enough money to cover higher payments. It’s a problem for a number of borrowers: A recent report from the Consumer Financial Protection Bureau showed that lenders denied applications for mortgages due to insufficient income at the highest rates since 2018.

Despite rates hovering in 7 percent territory, mortgages are still among the cheapest loans you can get — credit cards and personal loans often have higher rates. However, you’ll want to have a concrete understanding of your LTV ratio before submitting an application to a lender.

Say you have an LTV ratio of 50 percent and do a cash-out refinance to pay for a renovation, and the new loan terms put your LTV ratio at 70 percent. That still looks good in the eyes of the lender. However, if you need more money and you wind up with an LTV ratio above 80 percent after you add on the cash, you may encounter some trouble.

Pros and cons of using a cash-out refinance for home improvements

Pros

• Access to a big chunk of cash: You can access the money to improve your home by tapping into your home — specifically, the home equity stake you’ve already built.
• Upgrades can translate to an uptick in value: Depending on the type of renovation, the improvements could increase the value of your property and further build your equity, and make your property more desirable in the eyes of a future prospective buyer.
• Tax deduction: You can typically deduct your mortgage interest if you use the funds from your cash-out refinance to make improvements that increase your home’s value. Improvements can also boost your tax basis in the house, lowering your capital gains tax liability if you sell.

Cons

• You owe more: Your total mortgage debt will increase with a cash-out refinance. So if you were within a few years of paying off your original loan, the extra cash you borrowed for your home project will be a setback. It will also result in a smaller profit if you sell.
• Depleted home equity: With a cash-out refinance, you’re borrowing against your home equity, turning the amount you own into an amount you owe. You’ve diminished your outright ownership stake, in other words.
• Closing means paying: You’ll need to pay closing costs when you refinance like you did with your original mortgage loan. Though usually less than the first time ‘round, these costs can add up to around 2 to 3 percent of the loan amount.

Important considerations when cash-out refinancing for home improvements

Anytime you’re borrowing money against the roof over your head, you need to carefully consider all the implications. With a cash-out refinance, here are some of the most important pieces to understand.

• You’re going to pay closing costs: According to Freddie Mac, the average costs for a refinance are around $5,000, but this tab can vary widely depending on the value of the loan, the local taxes and the fee structure of your lender. Additionally, if you pay money to buy down the rate, that will increase your upfront expenses. The more you have to pay – which usually just comes out of the cash portion of the proceeds – the less you have to work with for your home improvement project.
• You’re going to have a new loan with a new rate: You’re replacing your initial mortgage with a brand new loan, so there are important calculations to consider. Plus, you’re increasing the amount of money you owe, so you need to make sure that you are comfortable with your new monthly payments.
• You’re going to need to figure out what your home is worth: Your equity level is based on how much money you owe on your current mortgage versus what your home is worth today. It’s important to go into the process with an estimate of your property value based on today’s market. A lender will still require an appraisal to verify its real value, but you’ll have a good idea of your potential borrowing power.
• You’ll have some borrowing limitations: Most lenders will want you to maintain an 80 percent loan-to-value ratio, although you might find a lender willing to let you borrow a bit more – up to an 85 percent loan-to-value ratio.
• You’re not going to get the money immediately: A cash-out refinance requires a full underwriting process, which means you’re going to need to wait for a lender to thoroughly review your finances. Don’t bother starting a project until you actually close on the new loan, which can typically take a month and a half.

Alternatives to refinancing for home improvements

A cash-out refi isn’t the only option for funding home improvements. There are other ways. Among them:

• Home equity line of credit: Commonly shortened to a HELOC, a variable-rate home equity line of credit gives you access to funds as you need them instead of a lump sum of cash that you would receive in a cash-out refinance. Since they’re withdraw-as-you-go, HELOCs can be ideal for long-term renovation projects, in which you often pay contractors at set intervals.
• Home equity loan: A fixed-rate home equity loan is a second mortgage based on the equity you have in your home. So, rather than replacing your mortgage with a brand new loan – as you would with a cash-out refi – a home equity loan is another loan with a separate set of payments that remain the same (unlike a HELOC, which can change as rates go up or down).
• Personal loan: Personal loans are unsecured, meaning you are not borrowing against your home (or any other asset). While that can feel better for you as a borrower, it tends to feel riskier for the lender, which is why these come with higher rates and smaller maximum loan amounts.
• Credit card: Credit cards generally come with higher rates than any of the other borrowing options on our list. But if you have a relatively minor home project planned, there are some cards that come with 0% APR introductory periods. If you can pay off your balance in full prior to the end of that period, this can be an option to pay no interest whatsoever on your purchase.